If you need to take out a loan, you’re going to have to pay back that loan with interest. Interest is paid in exchange for the convenience of borrowing money. It’s sort of like the price on borrowing money in addition to the price of the money being borrowed itself.
Financial lenders are taking a risk by lending you money. Typically, the higher the risk, the higher the interest rate. But you aren’t the only factor a lender uses to assess the risk. For example, if the economy tanks, and your occupation’s market suffers as a result, you might lose your job, regardless of your perfect credit score.
Mortgage interest rates tend to be a bit more intricate.
Interest Rates and the Secondary Market
Despite what many borrowers think, the lender does not typically hold onto a borrower’s loan. Instead, these loans usually enter what’s known as the secondary mortgage market.
Before we proceed, we need to define a couple of terms:
- Aggregator – A third party investor that buys new loans from lenders, often an institutional or a mutual fund investor
- Mortgage-backed security (MBS) – A “package” of loans put together by the aggregator
- Tranche – A share of an MBS that other investors can purchase
A home owner’s monthly mortgage payments wind up being the return on investment (ROI) that the final investors make from purchasing tranches. By selling your loan to an investor, the lender makes their money back immediately.
This process involves both the aggregator and the mortgage lender to act as middlemen that try to please both the borrower and the investor. They need to find the middle ground between a low interest rate that favors the borrower and a high interest rate that favors the investor. Both the borrower and the investor need to be pleased in order to go through with any transaction.
In short, mortgage interest rates are determined by the secondary market.
But all of these components are contingent on each other. The aggregator buys the loan from the lender, but the purchase price is determined by the price at which the tranches are currently being sold. But, the initial loan borrower won’t take out a loan if the interest rate is too high.
How Investors Affect Mortgage Rates
Going deeper now; the price the final investors are willing to pay for tranches is determined primarily by 3 factors:
- The inflation rate
- The price of United States treasuries
- The Federal Reserve
A steady rise in the rate of inflation is generally the sign of a healthy economy, provided there is a direct proportion in the rise of employee wages. For lenders, rising inflation rates can be problematic. Inflation causes money that is borrowed now to be worth less when it is paid back. If a rise in inflation is predicted, investors may push for higher interest rates to compensate.
Investors frequently compare tranches with U.S. treasuries. Because borrowers with 30-year mortgages typically refinance or move after about a decade, mortgage loans are typically compared against 10-year treasuries. But because U.S. treasuries are much safer investments, investors demand a higher ROI on tranches.
When certain rates are changed by the Federal Reserve, it has an effect on mortgage rates. If the federal funds rate is increased, borrowing money would become more expensive which would cause the amount of available money to lower, which would help cause inflation to stop rising.
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